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Prescience Investment Group is a research-driven, performance-oriented investment firmMon, 25 Aug 2014 22:40:41 +0000en-UShourly1http://wordpress.org/?v=3.8.5US Antimony Corp (UAMY): Evidence Calls for Regulator Scrutiny; Pump Points to Substantial Downsidehttp://presciencefunds.com/uamy-pump-points-substantial-downside-evidence-calls-regulator-scrutiny/
http://presciencefunds.com/uamy-pump-points-substantial-downside-evidence-calls-regulator-scrutiny/#commentsThu, 20 Sep 2012 11:46:32 +0000http://presciencefunds.com/?p=974In this report, we present a number of reasons why investors in United States Antimony Corp. (“UAMY” or the “company”) should be especially cautious. We believe the company is currently violating both Regulation S-K disclosure requirements and AMEX listing requirements. Our evidence suggests the company’s board does not consist of a “majority” of independent directors, that UAMY may be trading on the AMEX in violation of that exchange’s rules. We also believe the company is pumping its stock price and in doing so may be violating Regulation FD by providing potentially material, non-public information on a selective disclosure basis. We believe these potential violations and the benefits of its AMEX listing have enabled a successful effort to inflate the company’s market valuation beyond reasonable measure.

We urge the AMEX to halt trading in UAMY’s shares pending resolution. Further, we urge FINRA and the SEC to investigate these potential violations and to mandate corrective action in an effort to protect public shareholders.

We have also discovered evidence that UAMY’s business model is structurally flawed, rendering it noncompetitive in price relative to cheaper foreign sources of antimony. With a few price checks, we have been able to verify that imported antimony prices are being sold in the U.S. at least 10 – 15% cheaper than UAMY’s identical products. This structural price gap has persisted for many years, explaining why the company has never been able to earn a sustained profit.

We believe UAMY has an intrinsic worth best approximated by its current book value of $0.20 per share, ~90% below current trading levels.

Background

As a research-driven investment manager, Prescience Investment Group goes to great lengths and commits substantial resources to verifying the claims companies make in their filings with the United States Securities and Exchange Commission (the “SEC”). To date, two of five of the companies we have exposed as engaging in fraudulent behavior have been halted from trading and delisted from major exchanges to the Pink Sheets (ABAT (here) and APWR (here)). In addition, the SEC is pursuing a detailed investigation into APWR to determine whether it or any of its personnel violated federal securities laws.

Consistent in nature with other troubled companies we’ve assessed in the past, a thorough analysis of UAMY’s accounts and filings reveals numerous red flags, including a history of never having produced sustained positive free cash flow, poor earnings quality, and a lack of disclosure and transparency.

A prior report published by Spruce Point Capital Management (here) does an excellent job of documenting other red flags, including:

A promotional campaign that misrepresents the company’s earnings potential

Failure to provide investors independently verified proven or probable reserves in Mexico, which is a primary focus of its potential upside

Numerous undisclosed risks

Extreme overvaluation relative to proven antimony producers

A weak capital structure that disadvantages common shareholders in favor of preferred shareholders

In this report, we’ll shed light on these issues and additional causes for concern discovered during our own research process, including the following:

Violations of Reg S-K

Potential violations of AMEX listing requirements that mandate a majority of directors be independent

Structural issues rendering UAMY’s business model as uncompetitive

A troubling web of insider dealing and related party transactions

Pumping the Stock Price and Potential Violations of Regulation FD

Undisclosed and material litigation claiming UAMY abetted a fraud

5 year old internal control deficiencies that remain unresolved

An auditor with its own audit deficiencies signing off on the company’s financials

UAMY is in Violation of Reg S-K: Failure to Disclose >10% Customers

Regulation S-K spells out what companies are required to disclose in the nonfinancial portion of their filings with the Securities and Exchange Commission. As a part of the 1933 Securities Act, Reg S-K is meant to ensure buyers of securities receive complete and accurate information before they invest. The complete body of this regulation can be found here.1

Item 101(c)(1)(VII) of the regulation explicitly mandates that companies name the customers that represent 10% or more of the company’s annual revenues. Specifically, they are required to disclose the following:

The dependence of the (business) upon a single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the segment. The name of any customer and its relationship, if any, with the registrant or its subsidiariesshall be disclosed if sales to the customer by one or more segments are made in an aggregate amount equal to 10 percent or more of the registrant’s consolidated revenues and the loss of such customer would have a material adverse effect on the registrant and its subsidiaries taken as a whole. The names of other customers may be included, unless in the particular case the effect of including the names would be misleading. For purposes of this paragraph, a group of customers under common control or customers that are affiliates of each other shall be regarded as a single customer.

UAMY provides the following disclosure about its customers in its recent 10-Q:

During the six months ended June 30, 2012, approximately 86% of the Company’s antimony revenues were generated by sales to three customers. Loss of any of the Company’s key customers could adversely affect its business.

Its high customer concentration and absence of specific disclosures of those customers’ names appears to be a clear violation of Reg S-K.

Absent and opaque disclosures appear to be a recurring theme for this business. In the next section we explore in greater detail why we believe the company may be hiding its customers’ identities.

We Believe UAMY may be in Trading on the AMEX in Violation of Listing Requirements

In order to qualify for listing on the AMEX exchange, companies are required to meet specific listing requirements. The governing literature can be found here. According to Section 802, “at least a majority of the directors… of each listed company must be independent directors…” Furthermore, the rules clearly state that executive officers, their family members, and board members who have done business with the company in amounts exceeding 5% of the organization’s revenue in any of the most recent three fiscal years shall not be deemed independent.

Accordingly, it is clear that CEO John Lawrence and his son Vice President Russell Lawrence, as executive officers and relatives, do not qualify as independent directors. Because UAMY’s board is currently composed of six members, the remainder of its directors must meet the AMEX’s definition of independent in order for the company to be in compliance with the exchange’s listing requirements.

The company released an 8-k in February 2012 announcing the appointment of its newest director Whitney Ferer. It describes him as “one of the largest traders of antimony metal and oxide in the United States.” UAMY describes itself in its 2011 10-K as “the only significant US producer of antimony products.” We found it difficult to believe that one of the largest US traders in antimony is not also trading the antimony of the only significant US producer. Furthermore, we wondered whether the company might have something to hide by not disclosing its largest customers as mandated by Reg S-K.

We conducted an independent investigation into Mr. Ferer’s dealings with UAMY and received in the email provided below an attestation from Ferer himself to the fact that he has done business with United States Antimony for over 25 years. It is very likely Mr. Ferer does not meet the AMEX’s definition of independence and that UAMY is trading on the AMEX in violation of that exchange’s rules.

Mr. Ferer also sheds light on the structural issues facing UAMY that will continue to prevent it from making money in the future. Put simply, antimony is cheaper to purchase from foreign sources, even when factoring in transportation costs. This explains why, even by UAMY’s own admission, they only supply 4% of the U.S. market for antimony products: Few rational purchasers would buy UAMY’s antimony product at such a large premium being that it is a pure commodity with no differentiating factors.

Email Evidence Proving Board Member Ferer is Not “Independent”

Complex Web of Insider Dealing

Our findings regarding Mr. Ferer are just one of many instances that reflect UAMY’s opaque business dealings. In the diagram below, we have outlined the complex web of insider and related-party dealings. The key take-away is that every individual appears to be benefitting at the expense of shareholders. For over 10 years, the CEO John Lawrence has benefitted from renting equipment and an airplane to the company. Moreover, for 7 years the CEO’s son Russell Lawrence has been a member of the board and received payments. Long-time board member, Leo Jackson, who recently resigned due to “health concerns” was also a beneficiary of the company’s Mexico growth aspirations. In 2006, he benefited from the sale of the 50% interest in United States Antimony, Mexico S.A. de C.V. “USAMSA.” The 50% interest was acquired from Production Minerals, a company that was 34% owned by Mr. Jackson. Mr. Jackson has continued to extract fees from the on-going permitting and construction-related activities in Mexico, as have board members Russell Lawrence and Gary Babbitt. Further, Mr. Babbitt, a lawyer by training, has also been the beneficiary of company money by acting as legal counsel and receiving fees for his services.

United States Antimony Related Party Dealings

Pumping the Stock Price and Potential Violations of Regulation FD

The SEC adopted Regulation FD (“Reg FD”) to address the selective disclosure of information by publicly traded companies and other issuers. Reg FD provides that when an issuer discloses material nonpublic information to certain individuals or entities-generally, securities market professionals, such as stock analysts, or holders of the issuer’s securities who may well trade on the basis of the information-the issuer must make public disclosure of that information. In this way, the new rule aims to promote full and fair disclosure.

We have obtained evidence that the company’s IR firm is disbursing information to a select group of interested parties. To illustrate, we have provided a copy of an email dated September 9, 2012 from the company’s IR firm in which it leaks information of UAMY having been “approached by Mexican military for antimony products for ammunition.” Considering that UAMY has disclosed that it has a small customer base of high concentration, we believe this news could be deemed material and should be disclosed to all investors through an 8-k filing or publicly disseminated press release.

Indeed, UAMY’s stock price rose ~7% on the Monday following this weekend distribution. By Thursday’s close it had risen 10%; at its Friday peak following this announcement, the stock had risen 16%.

Selective Disclosure Email From UAMY’s Retained IR Firm

Another email recently distributed could be interpreted as selective disclosure of earnings ahead of a public announcement. On July 26, 2012, UAMY’s IR rep distributed an email announcing he would purchase UAMY’s warrants just days ahead of the company’s second quarter earnings, which were to be released on August 10, 2012.

Email From UAMY’s Retained IR Firm With Perception of Insider Dealing

UAMY’s stock price rose 9% on the day of this distribution. By the next day’s close it had risen 15%; at its peak on the following day, the stock had risen 19%.

We believe UAMY’s stock today trades at levels that defy comprehension relative to our assessment of its intrinsic worth.

Failed Promises to Show Proven or Probable Reserves

UAMY has been baiting its shareholders for years on the promise that its Mexican operations hold vast amounts of antimony, gold, and silver. However, we find it baffling that they refuse to pay any geological experts to validate what they actually have. Moreover, the company has a history of misleading investors with the promise of providing more information, only to go silent and provide no additional evidence of their holdings. For example, in an 8-k filing, UAMY announced that on April 19 and 20, 2012, Grupo Mexico, the largest mining corporation in Mexico, took samples at the Los Juarez mining concessions of USAMA. On April 27, 2012, Grupo Mexico informed the Company that it would begin diamond core drilling for silver, gold and antimony on the Grupo Mexico concession adjacent to the USAMSA property. After 5 months, the company has offered no single update to shareholders about the samples that were taken by Grupo Mexico or the results of any holes that have been drilled. Likewise, on August 20th, the company announced that assay results from some rocks in Mexico would be expected “shortly.” Nearly a month has passed, and the company has offered no results. This further illustrates the pattern of opaque disclosures, and the company’s propensity for not following through on delivering tangible evidence of its antimony holdings to investors.

We believe UAMY has also made material omissions and misstatements in its disclosures regarding legal proceedings against the company. A search of the public record reveals that UAMY, its wholly-owned zeolite subsidiary, some business associates, and its CEO John Lawrence were named as co-defendants in a case filed in 2010 alleging fraud, racketeering, and other legal infractions and seeking potential damages amounting to many millions of dollars.

The plaintiff Compania Inversora Corporativa SA (“CIC”) is a Mexican holding company that has existed for over 50 years and operates a diversity of Mexican and international business ventures, collectively employing over 10,000 people. CIC claims that it was solicited to invest in a company that supposedly owned the mining rights over UAMY’s wholly-owned zeolite mining operation (“BRZ”) and told that its investment would go toward expanding the BRZ mine site and adding buildings and/or purchasing equipment. The lawsuit claims that CIC was sold a bad bill of goods and that its $1 million investment never went toward expanding BRZ and was instead distributed to “former investors in a manner closely resembling a Ponzi scheme”. It states that it never received any securities or a return on its investment and that the business entity it invested in was later terminated without notice.

In another potential violation of Reg S-K (Item 103), UAMY makes an incomplete disclosure regarding the situation in its 2010 10-K and makes no disclosures of the matter in any subsequent filing. UAMY’s 2010 10-K states only that UAMY “has been named in a lawsuit against one of its previous customers, currently we do not anticipate any contingent liabilities arising from these matters.”

However, Reg S-K requires providing investors with “the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, a description of the factual basis alleged to underlie the proceeding and the relief sought.” UAMY discloses none of these items, information any rational investor would desire for conducting normal-course due diligence.

Further, CIC’s lawsuit claims that UAMY CEO John Lawrence played a central role in selling CIC on the investment opportunity, that he met with the Plaintiff on multiple occasion, and that he was aware of and abetted the fraud being perpetuated. It also claims that UAMY/BRZ pocketed $300,000 of its misappropriated funds. UAMY’s 2010 and subsequent 10-K’s, however, state the following:

We are not aware of any involvement by our directors or executive officers during the past five years in legal proceedings that are material to an evaluation of the ability or integrity of any director or executive officer.

We are not certain of the current status of this proceeding. However, we should note that every other filing subsequent to the 2010 10-K states that “USAC is not a party to any material pending legal proceedings, and no such proceedings are known to be contemplated.”

We believe that UAMY may have made material omissions and material misstatements in not being forthright in the disclosures it is required to make to investors.

Internal Control Deficiencies Unresolved for Over 5 Years

UAMY has a long history of material weaknesses in internal control over financial reporting. The following internal control deficiencies were noted in UAMY’s 2011 10-K and have remained unresolved for the past 5 years:

The absence either internally or on its Board of Directors the expertise to produce financial statements to be filed with the SEC.

The absence of proper segregation of duties within significant accounts and processes and the absence of controls over management oversight, including antifraud programs and controls; and. The president authorizes the majority of the expenditures and signs checks.

Inadequate documentation of controls and monitoring of internal controls over significant accounts and processes including controls associated with the period-end financial reporting process

The absence of controls over the selection and application of accounting principles that are in conformity with generally accepted accounting principles and the sufficient expertise in selecting and applying generally accepted accounting principles, including controls over non-routine transactions and controls over the period-end financial reporting process.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. In this case, UAMY’s auditor had to take extra measures in order to get comfortable with its financial statements due to inadequate processes that would ensure the reliability of its financial reporting. Further, this resulted in UAMY’s auditor identifying material misstatements in the company’s financial statements during its year-end audit.

During the quarter ended December 31, 2011, UAMY finally took a step toward resolving these matters by hiring CFO Daniel L. Parks, a Certified Public Accountant, to assist with the financial statements. However, according to his biography, it is not evident that he has any experience working in the CFO role for a publicly traded company. Moreover, the CEO John Lawrence is still acting as Treasurer according to the last 10-k filed in March 2012, leaving open the potential for financial mismanagement.

An Auditor with its own Audit Deficiencies Signing off on the Company’s Financials

A common theme that has emerged from our experiences in bringing to light troubled companies is that many tend to share the same auditors. UAMY’s current auditor DeCoria, Maichel & Teague P.S. (“DMT”) received a PCAOB inspection in 2010 that concluded the following:

The inspection team identified what it considered to be audit deficiencies. The deficiencies identified in one of the audits reviewed included a deficiency of such significance that it appeared to the inspection team that the Firm did not obtain sufficient competent evidential matter to support its opinion on the issuer’s financial statements…

The PCAOB is an independent third-party “nonprofit corporation established by Congress to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports”.

DMT’s average mining client is a bulletin board or pink sheet listed penny stock with an average market capitalization of $10 million.

While we understand that making money in junior miners can be a crapshoot, we should note that not a single equity in the above roster has delivered a positive total return for its shareholder in the past 5 years.

Conclusion: UAMY Appears Headed Back to the Bulletin Board

It took United States Antimony 40 years to attain its listing on the American Stock Exchange, but based on the evidence it could be weeks before losing it. To achieve this listing milestone, the company had to inflate its stock price above $3.00 per share and make some corporate governance changes, such as creating an independent board. To accomplish the minimum share price requirement, the company appears to have embarked on a series of promotional campaigns geared toward retail investors, and based them on the hope that their Mexican operations would produce windfall profits for shareholders. As has been previously reported, the company’s Mexican subsidiary was once written-off as worthless and was ultimately acquired from a company director for a pittance. But, it is no wonder the company’s assets have historically had little value – due to structural issues in the global antimony market, US antimony producers are noncompetitive on price and struggle to make a profit.

Moreover, related party transactions appear to be the normal practice for UAMY. Nearly all of their current and former directors have been beneficiaries of payments for things such as royalty payments, legal fees, equipment leases, aircraft rentals, and construction services tied to the Mexico operations. We have also provided evidence that Mr. Ferer, a recently appointed board member, is also not independent due to his admission that he has done and continues to do business with the company. In violation of Reg S-K, UAMY does not currently disclose who its largest customers are, so we are left to speculate whether UAMY is involved in large, undisclosed insider dealings with Mr. Ferer’s company.

We have also found additional evidence of material and undisclosed information relating to litigation with the company’s zeolite operation. This also fits the pattern of opaque reporting and limited disclosure to investors. We have not gained any comfort in UAMY taking adequate steps forward to bolster its governance and financial reporting controls. The company’s internal controls over financial reporting are reportedly weak and have not been remediated for multiple years. The appointment of a former CFO who lacks any public company operating experience does not provide shareholders any meaningful assurance that these problems will be resolved. However, perhaps most disturbing is that UAMY may be engaging in selective disclosure of material information, which would be a violation of Regulation FD.

We intend to submit our findings to the AMEX, FINRA and the SEC for proper review.We urge the AMEX to halt trading in UAMY’s shares pending resolution of these matters. Further, we urge FINRA and the SEC to investigate the company’s potential violations and to mandate corrective action in an effort to protect public shareholders.

(1) UAMY is not a ‘Smaller Reporting Company’ as defined by Reg-S-K; therefore, it does not qualify for the more lenient ‘scaled disclosure’ requirements afforded to such companies. Accordingly, UAMY does not check the ‘Smaller Reporting Company’ box in the cover pages of its HTML-format filings (see most recent 10-Q in HTML format HERE), instead acknowledging its status as an ‘Accelerated Filer’. However, it inexplicably claims ‘Smaller Reporting Company’ status in its XBRL-format filings (see most recent 10-Q in XBRL format HERE).

Disclosure: We are short and own options on UAMY and stand to realize gains in the event that the price of the stock declines. To the best of our knowledge, all information in this article is accurate and reliable, but we present the information “as is”. We will not necessarily update or supplement this article in the future. Following publication, we may transact in securities of the company covered herein.

Shares of Student Transportation (Nasdaq/TSX: STB) are trading near an all-time high, propped up by retail investors attracted by the feel-good story of investing in a company that provides school bus services to children. As a return on their investments, the company pays a monthly dividend with an optically attractive dividend yield of 8%. In reality, STB’s business and financial strategy benefits its bankers and management, and is not accretive to shareholders. STB’s financing scheme relies on raising increasing sums of capital from new shareholders and creditors to maintain its irrationally high dividend, which is akin to “taking money from Peter to pay Paul.” As a result, in the absence of new capital, we believe STB’s dividend would ultimately be cut, and its stock price would fall closer to our fair value target of $2.00 per share, or 70% below the current stock price.

This article summarizes key points that we have put together in a detailed report accessible here.

As shown below, STB has never been able to cover its dividend from its operating free cash flow and is projected to continue its shortfall again in FY 2013 (See Appendix).

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Instead, STB has repeatedly raised money through dilutive security issuances from new investors to pay a dividend to an ever expanding group of existing and new investors. For example, STB recently listed their shares on the Nasdaq in September 2011, and wasted no time tapping new investors for C$75m in February 2012 with a dilutive stock offering. We believe the company’s listing on the Nasdaq signals that they have largely maxed out financing from the Canadian market. The dividend is really the only thing attracting retail investors to their stock, meaning that any strain in financial markets going forward could have severe consequences for the stability of the dividend.

Growth Story Fantasy

The school transportation industry is fragmented, but dominated by two large foreign competitors that have already consolidated a majority of the industry. STB has been selling investors on their acquisition growth strategy given the anemic organic growth in the industry. STB has acquired 47 independent school bus companies over the years in smaller markets where they believe there are lower levels of competition and operating costs. While on the surface this makes intuitive sense, the company’s own financial results do not support the conclusion that the strategy is yielding benefits. There are no revenue synergies and few cost synergies to justify STB’s levered acquisition spree. Overall, the economics of the student transportation industry are highly competitive, capital intensive, increasingly regulated, and result in low margins and returns to shareholders.

Misaligned Incentives: Management and Bankers Win, Shareholders Lose

STB is a banker’s dream client because of all the debt and equity capital they require, M&A deals they complete, and fuel hedges they execute. In return for the millions of fees that STB pays banks, the company receives glowing “strong buy” recommendations and unjustified price targets backing their levered acquisition spree. Of course, STB’s bankers have no accountability or alignment with the shareholders, but what about STB’s management and their alignment and incentive structure? STB’s management owns less than 1% of the common stock, but instead gets rewarded with a preferential Series B stock that allows them to regularly sell shares back to the company. STB’s management has liberally sold millions of dollars of stock back to the company, while virtually no common shares have been repurchased under the common stock buyback program. Worse yet, the management are rewarding themselves with bonuses tied primarily to revenue growth, instead of measures that are directly measurable to shareholders such as EPS or cash flow growth. This allows the management to reward themselves richly for growing revenues at any price. Investors need look no farther for evidence of overpayment than the massive goodwill and intangible accumulation on the company’s balance sheet, which now totals 44% of total assets. As another measure of STB’s outrageous management compensation plan, the founder and CEO reaped $1.8 million of total compensation in 2011, which is greater than STB’s 2011 EPS. The amount is also larger than almost any CEO of a publicly traded North American transportation company, even those with enterprise values 4x larger (See Appendix).

Retail Driven Ownership Leading to Massive Stock Overvaluation

Looking at STB’s shareholder base, it is entirely clear that institutional investors have refused to own shares of the company. As of March 31, 2012, 66% if shares were in the hands of retail investors, leaving 33% in the hands of institutions. However, even this number is misleading due to the fact that two institutions own approximately 21%. Management owns less than 1% of the common stock of the company.

Based on the points described above, it is clear that institutional investors and management are completely unwilling to hold the stock at any price. Yet, retail investors have driven the valuation up to a level which is nearly double that of comparable companies. STB currently trades at 11.5x EV/ 2012E EBITDAR and 61x Price/FY 2013E EPS vs. peers which trade at only 5-8x and 7-12x, respectively. No transportation company has ever been sold in a private transaction at a multiple that even comes close to STB’s current value. It seems clear that retail investors have simply ignored the valuation of STB, its flawed strategy, and misaligned incentive structure. Otherwise, they are being drawn to the highly promotional nature of the company’s press releases, such as a recent release that proclaimed a “Historic Shift” taking place in the school bus market. The absurdity of these press releases, and the company’s valuation, is also seen from the perspective that investors are ascribing a value of $87,000 per school bus, which on average is 6 years old; brand new buses can be purchased for much less.

Conclusion: Buyer Beware

As with any financing scheme, the game ends when the company can no longer raise money from new investors to continue paying out existing ones. STB’s recent listing on the Nasdaq, rapid stock offering, and weak insider and institutional ownership are clear signals that the company is having difficulty finding greater support for their misguided acquisition strategy. Meanwhile, global tightness and instability in financial markets does not bode well for capital intensive business such as STB’s going forward. Investors are strongly cautioned to consider the misalignment of incentives with this company, and the future security of the dividend.

Business Overview

Student Transportation Inc. is reportedly the third largest provider of school bus transportation services in North America with 9,000 vehicles and revenues of $355 million as of LTM 3/31/12. The company’s operations are located in Ontario, Canada and 15 states across America. Below is a quick overview of the business by revenues.

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The company has grown its business primarily by executing on its A-B-C strategy. Acquisitions have formed the basis for the majority of the company’s growth over the years. STB has completed 47 companies since its inception. As we’ll explore in greater detail in this report, many of these acquisitions are privately owned, independent regional operators. Bidding activities are directed toward school districts that have chosen to solicit bids from private operators for their school bus transportation contracts. These contracts are primarily awarded by school districts based on a competitive public bidding process or Request for Proposal, on the basis of the “lowest responsible bid.” Lowest responsible bids enable school districts to consider factors other than price in awarding a bid, such as safety records and initiatives, driver training programs, community involvement and quality of service. Conversions are focused on privatizing school districts in regions contiguous to the company’s existing operations. Approximately 68% of the school bus market is operated by school districts, which allows companies like STB to claim there is a large opportunity to grow by converting school districts to outsourced operation at substantial cost savings. To date, STB has completed only 10 conversions.

History and Path to the Capital Markets

The company was initially founded in 1997 by Dennis Gallagher upon his departure from Laidlaw Inc. Prior to joining Laidlaw, Mr. Gallagher sold his school bus transportation company to Laidlaw in 1987 and held a senior position with the company. The formation of Student Transportation nearly faltered from the start, when Laidlaw filed an injunctive motion claiming its executives breached their non-compete contracts, although the courts ultimately denied Laidlaw’s motion for preliminary and supplemental injunctive relief. The company came public in Canada in 2004 on the Toronto Stock Exchange through an Income Participating Securities (“IPS”) offering of C$116 million which included IPS units and Senior Subordinated Notes paying 14%. Over time, the company has eliminated the IPS structure and Subordinated Notes through exchange offers, convertible bond and multiple stock offerings.

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Given that the origins of the company’s management and business operations are primarily in the U.S., the choice of listing in Canada through the IPS structure appears motivated by the ability to access retail investor demand for income yielding securities. To this day, the company has maintained an unrealistic monthly dividend policy of $0.046 cents per share which provides a current dividend yield of 8.0 percent. The company’s initial equity sponsors no longer own shares; today’s shareholders are predominately Canadian and US retail investors who own 66% of the shares. The two largest institutional shareholders are Societe Nationale de Chemins de fer France (“SNCF” 12%) and Caisse de Depot (9%).

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In July 2011, STB made its trading debut for its Class A common shares in the U.S. on the Nasdaq. According to the company, the listing “Creates access to a larger shareholder base and allows U.S. institutional and retail investors to trade shares more easily and with greater liquidity.” Since the listing event, we don’t believe STB has garnered serious investment from any major U.S. financial institution except a small firm called WealthTrust Axcicom. However, we believe the company has used the listing to attract additional retail investors who are gravitating towards the dividend. As we will explore later in this report, we believe the dividend is a fundamentally flawed financial policy, which the company is highly dependent on paying to sustain its investment appeal, and attract new equity capital for its levered growth trajectory.

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The company’s management owns 100% of the Series B shares and less than 1% of the common shares. Management is currently receiving Series B-3 shares as part of their annual Equity Incentive Plan (“EIP”). The Series B is entitled to dividends and receives certain preferences to common shareholders that are noteworthy, particularly a put option which allows management to force the company to repurchase their shares in annual amounts. This put option is accounted for as a liability on the company’s balance sheet, and we will evaluate the impact of management’s exercising these options on cash flow later in the report.

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Constrained Fundamentals in the Student Bus Market

The fundamentals in the student transportation market are characterized by limited barriers to entry and few proprietary points of differentiation to customers, capital and labor intensity, thin and pressured margins, increasing regulatory requirements, and constrained growth opportunities.

Limited Barriers to Entry; Few Proprietary Aspects of the Business

There are limited barriers to entering the student bus transportation market. Anyone that can purchase or lease a bus, obtain the proper licenses and insurance, can operate and compete in this market. Contracts with school districts are announced publicly and bid specifications are provided to any interested party. In advance of bidding, any prospective bidder can obtain information regarding that school district’s prior or existing school bus contracts. Prospective bidders may also obtain information on bids that were submitted to the school board in the past in connection with existing or prior contracts from competitors. The awarding of business contracts typically applies the “lowest responsible bidder” principle to determining which carrier is selected. While price is the predominant factor to evaluating this principle, other factors such as safety, quality of service, community involvement, etc. may be taken into consideration.

The industry is largely fragmented with some 500,000 buses in operation across the U.S. However, among the privatized, outsourced segment, the market has been largely consolidated in the past 10 years by UK publicly owned FirstGroup (LON.FGP) and National Express (LON.NEX)whom control approximately 52% of the privatized market. The top 10 providers account for 67% of the privatized market. The current industry concentration presents challenges to the acquisition strategy of companies such as Student Transportation, and will be more formally analyzed later in this report.

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Overall, significant competition, limited barriers to entry, and few proprietary aspects of the business that limit the ability for one bus company to differentiate itself, constrain the upside potential of the student bus transportation market.

Capital and Labor Intensive

The school bus transportation market is characterized as capital intensive. New school buses can cost $75,000, have a useful life of 12 years, and require significant maintenance capital expenditure costs. In practical terms, this means bus operators need to replace 8 %- 10% of their fleet each year. Keeping a younger bus fleet is advantageous as it helps minimize maintenance expense. Buses typically have low fuel mileage economy and require a large labor force to operate. Key components of operating capital costs include fuel, wages and salaries and benefits, insurance, regulatory compliance, and maintenance expenses. Wages and salaries are the largest cost of operations, with labor unions playing a large role in the industry. Approximately 15% of Student Transportation’s workforce is unionized.

Revenue and Cost Mismatch Pressuring Margins

As illustrated earlier, revenue contracts are awarded by school districts, which typically last from three to eight years. These contracts are primarily fixed price contracts and may include inflation escalators tied to the Consumer Price Index (“CPI”). Currently, the non-seasonally adjusted all U.S. CPI is 2.7% as reported by the Bureau of Labor Statistics. However, on the operating cost side of the industry, expenses are primarily variable and rising substantially. Take for example diesel prices: U.S. No. 2 Diesel Prices have risen 11% in the past year and 86% in the past two years according to the U.S. Energy Information Administration (“EIA”). Likewise, significant unionization of labor forces in the industry has resulted in increases in salaries in wages, while healthcare costs have also risen significantly. Furthermore, insurance policies must be renewed annually, and these costs have also been rising in recent years. A recent study by the U.S. Department of Transportation (“DOT”) in June 2009 indicated school bus fatal crashes represented the highest proportion of all bus crashes analyzed between 1999 and 2005. The overall mismatch between headline CPI inflation, and real inflation costs of the underlying business pose serious risks to levered school bus operators. For example, the industry’s fourth largest operator, Atlantic Express Transportation, filed for bankruptcy protection in 2002, and upon emergence from Chapter 11 in 2003, later went through another financial restructuring in 2009.

Increasing Regulatory Environment

Student bus transportation companies are required to comply with laws and regulations relating to safety, driver qualifications, insurance, worker overtime and other matters promulgated by various federal and state regulatory agencies including, among others, state motor vehicle agencies, state departments of education, the Federal Highway and Safety Administration, the National Highway Traffic Safety Administration and the Occupational Safety and Health Administration. Regulatory considerations are increasingly being factored into decisions by operators to remain in the industry. For example, Stagecoach recently cited regulatory considerations as a factor for selling its Dairyland business to Student Transportation in November 2011, even though it had a favorable financial profile. The Dairyland business and its financial impact on Student Transportation is analyzed more formally later in this report.

Outsourcing Market Share Shift Slow to Materialize

The growth of the industry through “conversions,” or outsourcing of bus operations to private contracts, has been slow to evolve. Currently, approximately 68% of the market is still operated by school districts, which in theory leaves a large market opportunity for private contracts to gain market share. Commentary provided by industry participants such as First Student (FirstGroup) and National Express also indicates that the market share shift to conversions has only been ~2% in the past few years. In practical terms, outsourcing has been slow to materialize due to municipal funding pressures, competing priorities for other issues faced by school districts, overall bureaucracy, labor union intervention, and limited changes in the total student population and like-for-like mileage growth. Take for example, the recently released report in May 2012 by the New York School Board Association. The results of the study indicate that 30.9% of NY school districts plan to reduce transportation in their 2012 – 2013 budgets. On a national level, the effects of reducing student transportation needs are becoming more tangible. For the month of April, the U.S. Labor Department reported that school-bus related employment saw the biggest decline in jobs for the month among all industries. These data points cast doubt on the industry growth story.

STB’s Flawed Acquisition Strategy

Now that we’ve provided an overview of the industry’s conditions, we can analyze whether Student Transportation’s aggressive acquisition strategy makes sense. According to the company’s recent February 2012 investor presentation, they have acquired 47 companies and target purchase price multiples of 3.5x – 5.5x EBITDA. Given the fragmentation of the industry beyond the largest providers, the company has focused on smaller operators in rural markets where they believe there are lower levels of competition and operating costs. While on the surface this makes intuitive sense, the company’s own financial results and incentive structure do not support the conclusion that the strategy is yielding benefits.

Let’s first look at the management incentive structure of the company. The company’s Short-Term Incentive Plan (“STIP”) provides that 40% of management’s cash bonus is tied to annual revenue growth, with another 20% listed as discretionary. A comparison of small-cap North American transportation firms reveals that Student Transportation is the only company tying short-term management bonuses to revenue growth. The most common compensation factors in the industry are EPS and return on capital targets. Therefore, we conclude that the company’s managers have a strong incentive to maximize revenue, and not cash flow or capital efficiency.

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Acquisitions of bus companies appear to offer few synergies to justify aggressive empire building. There are no identifiable revenue synergies from adding target companies. In an acquisition, Student Transportation adds its acquired contracts with school districts, physical assets, and employees. There may be some very marginal economies of scale in negotiating price concessions in purchasing fuel, new vehicles, and other related services. However, adding companies and entering new territories and regions also has added integration costs and expenses, such as adding new terminals and dispatchers. Overall, it does not appear that there is a net synergy benefit from an acquisition strategy in the student bus transportation industry. Take for example the company’s recently announced acquisition of Dairyland for $47 million. By analyzing the company’s recently filed pro-forma financial statements, we can assess the potential free cash flow impact. A cursory view of the deal indicates that STB’s free cash flow margin would increase from 7.4% to 8.4% or 100 basis points from the deal. However, this ignores any incremental capital expenditures required from adding this new territory in Wisconsin to the company’s geographic profile. A sensitivity analysis suggests that any additional expense above $3 million for this acquisition negates free cash flow margin expansion. A careful review of Student Transportation’s acquisition announcements indicate a steady disclosure of the revenue accretion from transactions, but provide no information on synergies or incremental costs associated with integration.

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Other challenges faced by Student Transportation of maintaining its acquisition strategy include the expense of identifying and sourcing a pipeline of actionable investment targets. With over 4,000 private contractors in the market, many local family businesses, the company is dependent on acquiring small operators who want to sell to Student Transportation versus retain control, or sell to a competitor who might have greater financial resources to pay for the business. Many of the company’s competitors have all been active in the M&A market in recent years, and have shown the willingness to pay for the right target, not just any target at all. See the section on Valuation for a complete list of M&A deals in the sector and how these deals compare with Student Transportation’s overall company valuation.

One way to assess the relative aggressiveness of the Company’s acquisition spree is to look at the goodwill accumulation that has been associated with these transactions. Intangibles primarily include contract values, non-compete agreements, and trade names. Goodwill is the excess of the deal price over working capital, PP&E, and intangibles less assumed liabilities. Goodwill and Intangible assets on the company’s balance sheet currently total over $221 million or 44% of the company’s reported assets. On average, 35% of the recent purchase price from acquisitions is attributable to goodwill.

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Is STB’s Financial Strategy Sensible in the Long Run?

With our foregoing discussion on the challenging industry dynamics and Student Transportation’s aggressive acquisition strategy, we are now in a position to assess if the company has an attractive and sustainable financial business model. The charts below show a remarkable result about the company’s capital allocation and margin profile. First, using publicly reported information in segment disclosures, we can compare Student Transportation’s adjusted operating margin (EBIT) with its two largest competitors, First Student and National Express. The chart shows very clearly that the company’s margins trail its competitors by 500 – 600 basis points, and their margins have been under pressure in the past few fiscal years. Meanwhile, both competitors have recently undertaken restructuring efforts in their North American student bus operations to improve and stabilize margins.

However, the two most striking observations from the charts are related to the company’s capital allocation strategy in the past five and a half years. From these charts we can see clearly the sources and uses of their cash flow, and can reach some conclusions about the financial model. Looking at the sources of cash, we see the company has generated $166 million from operations, but has raised more money from selling equity in the amount of $180 million in the same period. Approximately $212 million has been used for acquisitions, $146 million for capital expenditures, and $120 million for the dividend have been used. Actual free cash flow, or cash from operations less capital expenditures, has amounted to only $21 million. Typically, it would be prudent to use free cash flow for discretionary measures such as debt reduction, dividends, or share repurchases. However, the company’s free cash is significantly less than the amount used for dividends and Series B stock repurchased from management. Looking more closely at the capital allocation chart, we can see that cash from operations has been largely stagnant in the past three years, while total debt funded for acquisitions has increased by $154 million.

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Leverage Levels are High and Will Increase with More Acquisitions

The escalation of the company’s debt outstanding and margin pressure is concerning from the viewpoint that free cash flow has not increased commensurately. At the start of 2012, the company’s liquidity was not adequate with less than $4 million of cash on the balance sheet, and under $30 million of borrowing capacity under its credit facility. The company’s financial strategy has been to borrow short term for acquisitions, and then term out the debt with dilutive securities (straight equity issuance or convertible bonds). The company has the ability to exercise a $100 million accordion in its credit facility as well. According to our analysis, earlier this year the company was close to its covenant levels of 5.0x total leverage and 3.0x senior leverage. The covenants reference the company’s EBITDA metric and allow for pro forma adjustments based on the acquisitions being made. Accordingly, the company recently announced a C$ 75 million new equity raise at $6.85 per share on February 28, 2012. We also consider the company’s use of off-balance sheet operating leases amounting to over $70 million a form of debt.

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Transportation companies do not typically support such high levels of leverage due to many risk factors. The company has made use of the fact that it has contracted revenues of 3 – 8 years, and over 184 contracts which provide revenue diversity. However, 26% and 29% of its contracts mature in fiscal years 2012 and 2013 and there is no guarantee that contracts will be renewed; however, the company tends to have success in renewing contracts in the 90% range. With school districts under pressure to cut costs, re-opening contracts are expected to be fiercely competed. The company also has fuel protection measures in 60% of its contracts, with an additional 20% of exposures hedged through annual fixed-price fuel contracts with suppliers. However, pricing under these fuel contracts has annual rollover risk. To illustrate, pricing under new contracts has increased 30% year-over-year as of the current quarter.

How Shareholder Friendly is the Dividend and Series B Share Repurchase?

In the context of a management team that is highly incentivized to grow revenues, levering up to acquire companies, and not growing free cash flow, how wise is the dividend and management owned Series B stock repurchases? As we’ve illustrated earlier and in the chart below, the company’s free cash flow is not sufficient enough to cover either the dividend or Series B repurchases. The company also recently announced a common stock repurchase program up to $5 million, but has only purchased $100,000 of common stock. Where is the money coming from to fund these payments? The answer is that the money is coming from both creditors and new investors through share issuance. Put in this perspective, the dividend is not so friendly after all, but rather akin to taking money from Peter to pay Paul. The company will have to continue attracting new sources of capital to grow and maintain its current financial practices; otherwise, the dividend will be in jeopardy. As more shares get issued, the total annual cash dividend payment increases. Given that leverage is already at elevated levels and will increase with more acquisitions, the most likely outcome for the company is continued stock issuance in the foreseeable future. The common stock repurchase announcement also does not look friendly from the perspective that the company has repurchased $15 million of management’s Series B stock since 2007. The Series B has also been collecting dividend payments too, which further incentivizes management to maintain the dividend.

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Chart Observations: Cash from operations (CFO) per share peaked in 2009 and has been under pressure even as significant acquisitions have occurred. Free cash flow (FCF) per share is significantly lower than CFO per share; the gap has been widening recently. Dividends per share are higher than EPS, CFO or FCF per share. Cash for dividends and Series B buyback is approximately 75% of CFO and 111% of FCF.

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Valuation and Price Target

By almost every objective valuation metric, the company’s stock price appears overvalued. We have analyzed the company from the perspective of relative stock price performance, comparable trading companies, historical valuation, broker target prices, and precedent M&A deal values.

Relative Performance

STB’s share price has outperformed all its relevant peers and the Dow Jones Transportation Index (IYT) in the past two years. This outperformance is despite the fact that the company’s diluted share count has grown at a compounded average annual growth rate of 33%, and per share metrics have also struggled to match the rise in share price. In light of our previously highlighted concerns, STB’s share price appears terribly overvalued.

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Comparable Companies Analysis

By analyzing a set of comparable companies in the student bus transportation and North American mid-cap trucking universe, we see that an appropriate valuation range is 6.0x – 7.0x Adjusted Enterprise Value to EBITDAR. Some of truckers we compare STB against include: Knight Transportation (KNX), Heartland Express (HTLD), Marten Transport (MRTN), Celadaon Group (CGI), and Arkansas Best (ABFS). We have adjusted our financial figures to account for sizeable off-balance sheet operating leases that are commonly used in the industry. We treat these operating leases as a form of contractual debt and capitalize them through an NPV analysis. Student Transportation makes use of these operating leases in their business. On an Adjusted Enterprise Value to Revenue basis, an appropriate valuation range is 0.8x – 1.2x

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The following charts better illustrate the extreme overvaluation of the company’s shares. The shares appear overvalued on an EV/EBITDAR and Price/Earnings basis. The company is highly levered, and its dividend yield is matched only by FirstGroup, which is distressed and subject to a likely dividend cut.

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Historical Valuation

The following charts illustrate the company’s historical valuation in the past few fiscal years. The most interesting observation relates to the company’s enterprise value to vehicle fleet. A new school bus can cost up to $75,000, while the company’s enterprise value to vehicle ratio at 3/31/12 implies a valuation over $90,000. The average age of the company’s fleet is approximately 6 years old. Put in this context, the valuation implies a 25% premium to the value of brand new vehicle fleet.

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Precedent Transactions

Another sensible approach to evaluating Student Transportation’s intrinsic value is to look at precedent acquisitions in the student bus and transportation market. Fortunately, there are ample transactions to review that point to a consistent firm valuation. A very relevant and recent transaction comparable is National Express’ $200 million acquisition of Petermann in September 2011. Petermann is currently the 6th largest student bus operator in the U.S with 3,300 buses. This deal valued Petermann at 1.3x EV/Revenues, 6.8x EV/EBITDA and $60,000 per bus. On average, the analysis suggests valuations in range of 6.0x – 8.0x EV/EBITDA and 0.70x – 1.3x EV/Sales.

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Broker Price Targets

Student Transportation is currently covered by 4 brokers in Canada and 1 in the U.S., all of which have recently assisted the company to raise capital. The average analyst price target is $7.45 per share. Given the current stock price of approximately $7.10, the shares appear fully valued with limited upside potential.

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Price Target and Conclusion

We arrive at our share price target of $2.00 by applying realistic multiples to revenues, 2013E EPS and EBITDA based on the comparable companies and precedent transaction analyses. Given STB’s current share price of $7.10, we believe the stock is a strong sell and materially overvalued.

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Summary of Flawed Business and Financial Model

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Appendix

STB Will Continue Failing to Cover its Dividend

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STB’s Excessive Management Compensation

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STB’s Capital Structure

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Disclosure: We are short STB.

Additional disclosure: Please read our full disclaimer at the end of our report.

]]>http://presciencefunds.com/student-transportation-stb/feed/0Position Analysis: Planet Payment (PLPM)http://presciencefunds.com/planet-payment-plpm/
http://presciencefunds.com/planet-payment-plpm/#commentsMon, 25 Jun 2012 12:45:51 +0000http://presciencefunds.com/?p=873Planet Payment, Inc. (“Planet” or “the company”) is a defensible, emerging growth company whose dynamic currency conversion technology is being rapidly adopted by some of the largest payment processors and acquiring banks in the world. We believe the current stock price of $4.30 per share undervalues the company and that Planet’s impending re-IPO on the NASDAQ will serve as a catalyst to unlock value from current trading levels.

We believe the company has an intrinsic worth of $8 per share.

This article summarizes key points that we have put together in a 30 page research report available here (.pdf).

Investment highlights include:

PLPM is benefitting from powerful industry tailwinds:

Increasing shift from cash and check use to electronic payments

Visa and MasterCard’s filings show cross-border payment volumes are growing rapidly with international commerce

Increasing penetration of eCommerce sales on a global scale

Technology rapidly being adopted and is hard to replicate; likely acquisition target in a quickly consolidating industry:

After >$80mm of invested capital, Planet’s unique, outsourced technology platform is winning the business of some of the largest payment processors and acquiring banks in the w­­­­­­orld, including Global Payments, Vantiv and Barclays.

Its platform is built on a unified architecture with a centralized database as opposed to the processing platforms of some of its primary Dynamic Currency Conversion (DCC) competitors that use a regionalized architecture and database.

Patented, real-time per-transaction exchange rate calculations allow merchants to set rates on a per-transaction basis and enable enhanced data mining and reporting. Competitors do not have this capability and rely on treasury trading, settling transactions on a delayed basis and making it more difficult to scale.

Planet is a fast-growing, high-margin business with an attractive, sticky customer base and a multi-currency processing platform as the key growth driver. This gives it scarcity value in an industry characterized by accelerating M&A activity; we speculate the company will be an attractive acquisition target for any major processor.

Introduction

Planet Payment, Inc. is an emerging growth company that has reached the inflection point of profitability and has entered a self-funding, hyper-growth phase requiring little incremental capital expenditure. Its market valuation appears to reflect expectations for the typical lifecycle of a payment processor operating in a highly competitive environment, but Planet is far from a typical payment processor: We believe it is an infrastructure play on the mechanics of multi-currency payment processing and, after a decade and >$80 million of capital invested, one of the first companies to have laid the new foundation. It has only scratched the surface of a nascent and growing, multi-billion dollar global market opportunity in Dynamic Currency Conversion (DCC) and has a clear runway for sustainable growth over the foreseeable future.

The company is positioned at the forefront of several overarching changes taking place in the market for international payment processing, including shifts from paper to electronic payments, increased international travel and commerce, and increased adoption of eCommerce. The company has numerous untapped opportunities that are likely to greatly expand its market potential. The most notable immediate opportunity is the rapidly growing Latin American market, where the company has initiated a market expansion and we believe is on the verge of announcing partnership opportunities.

The company’s differentiated technological advantage is in its single, unified, currency-agnostic payment processing platform and is the reason Planet Payment has earned the business of some of the largest international banks and processors. The platform is built on a unified architecture with a centralized database as opposed to the processing platforms of some of its primary DCC competitors that use a regionalized architecture and database, allowing acquiring banks to support the growth of their international merchant customers without complication. Planet’s client base currently includes more than 45 acquiring banks and processors spanning more than 18 countries and territories across the Asia Pacific region, North America, the Middle East, Africa and Europe, including established markets in China, Hong Kong, Macau, Taiwan and Malaysia. In 2011 its base of active merchant locations grew more than 67%, by over 11,000, to almost 28,000 active locations.

As Planet’s global profile increases and the value of its solutions are realized in new geographic markets, the company experiences network effects, driving accelerating adoption of its services and increasing the value of its platform. This creates significant barriers to entry and results in earnings leverage for shareholders given the recurring revenue features of its customer contracts and largely fixed operating expense of its platform. In 2011, Planet’s revenue grew 37% to $41.9 million and EBITDA grew 226% to $5.9 million. Net Income was $2.4 million, versus a loss of $3.1 million in 2010.

We believe the company has a clear runway to continue to grow revenue at 30-40% per year over the next 3-5 years and that it has the potential to grow much faster. The current market price for Planet’s equity far understates the company’s long-term growth potential and presents a highly positively skewed risk-reward profile with little risk of permanent capital impairment over a multi-year horizon. We believe the equity has a fair value of $8 per share and that the exposure the company will receive in connection with its impending re-IPO will be a catalyst to unlock value from current trading levels.

Business Overview

Any international traveler is undoubtedly familiar with the experience of hastily performing mental calculations to determine what something will cost in their home currency. A US traveler in Japan, for example, may ask himself whether he should purchase an iPod for 15,800 yen. Even if he could estimate the payment amount in US dollars based on prevailing exchange rates, the final charge that would show on the credit card statement a month later would remain uncertain: The exchange rate eventually locked in would not be disclosed and the card-issuing bank would layer an international transaction fee of 2-5% onto the purchase. But if the iPod were priced in US dollars ($198.79) at the point-of-sale, the decision would be simplified.

Philip Beck, an international banking and corporate attorney by background, identified these and other issues inherent to the processing of multi-currency credit card transactions and in 1999 founded Planet Payment, Inc. to develop a solution. Planet’s platform simplifies the purchase decision by allowing for the final price, inclusive of exchange rate used and transaction fees charged, to be displayed at the point-of-sale or online in a purchaser’s home currency.

Planet Payment has grown into a leading provider of international payment processing and multi-currency processing services. It provides its services through more than 45 acquiring banks and processors to approximately 31,000 active merchant locations in 18 countries and territories across the Asia Pacific region, North America, the Middle East, Africa and Europe, primarily through acquiring bank and processor customers, as well as through its own direct sales force.

The company has built a proprietary, currency-neutral payment processing technology platform that serves as an outsourced, revenue-enhancing infrastructure that banks and processors subscribe to through long-term contracts. The platform is effectively a merchant-acquiring platform that operates seamlessly within the processing systems of Planet’s acquirer and processor customers and the front-end point-of-sale terminals and gateways of their merchants.

Planet manages its business through two operating segments: multi-currency processing services and payment processing services. Its multi-currency processing services, which make up ~65% of sales, provide merchants the ability to offer international cardholders the optional convenience of paying for purchases in their own currency, whereby Visa or MasterCard credit card purchases are made in the merchant’s local currency and converted after the card is presented (at the point of sale or online) into the cardholder’s home currency. Its payment processing services, ~35% of sales, comprise end-to-end authorization, capture, clearing and settlement services to its customers along with localized language support and online access to advanced reconciliation, reporting and analytics services.

How Planet Makes Money

Planet’s global, currency-neutral payment processing platform is offered to acquiring banks and processors on an outsourced basis, allowing them to provide multi-currency processing services to their merchant customers without large incremental investments in legacy systems. The company’s extensive relationships with the world’s leading point-of-sale providers allows merchants to offer multi-currency solutions through their preferred or existing systems.

Planet’s platform delivers value across the payment card transaction cycle, incentivizing banks and processors to enter long-term relationships with the company in exchange for recurring revenue generated from fees charged every time a purchase is made across the company’s network. Planet’s business model creates powerful network effects, which drive growth and operating leverage in its business, while contracts, which generally have an initial term of three to five years, offer stability and enhanced visibility of financial performance.

In 2011, Planet produced 56% of its revenue internationally and 44% in the United States, and in the first three months of 2012 Planet produced 57% of its revenue internationally and 43% in the United States.

The company distributes and cross-sells its services across a variety of points of sale with customized solutions in specific verticals, such as hospitality, restaurants and retail.

The business categorizes its revenue in two streams – as derived from Multi-currency Processing Services (65% of revenue) and Payment Processing Services (35% of revenue).

Multi-Currency Processing Services:

Planet Payment’s flagship offerings are its multi-currency processing services, including Pay in Your Currency (PYC) and Multi-Currency Pricing (MCP), which are offered by the company’s acquirer partners to the acquirer’s merchant base. They allow merchants to deliver a more personalized customer service, while enabling merchants to increase sales.

The company’s Pay in Your Currency service, commonly known in the industry as Dynamic Currency Conversion (DCC), identifies eligible foreign cards and provides consumers with the choice of paying for purchases or ATM withdrawals in their home currency based upon a conversion performed at the point-of-sale.

This provides certainty to the consumer, who would traditionally not find out the exact cost of their transaction until some future unspecified date when the card-issuing bank did the currency conversion at some undisclosed exchange rate and reported that cost on the credit card statement, often 20-30 days later. (In addition, transactions converted by the card-issuing bank often result in international transaction fees imposed on the cardholder, with the global average markup being between 2 and 5 percent.)

This explains why 70-90% of consumers who are given the option to pay in their home currency accept at the point-of-sale, and the acceptance percentage tends to increase sharply as a merchant’s sales people gain confidence explaining the benefits of DCC to customers.

The company’s Multi-Currency Pricing service is geared toward eCommerce merchants seeking to increase sales by attracting foreign customers. It allows them to set prices in multiple currencies while receiving payments in their own.

Topcreditcardprocessors.com ranked Planet Payment in the top 5 on their list of the best multi-currency processing companies that offer businesses the ability to accept payments in multiple currencies online.

Revenue from multi-currency processing is derived from foreign currency transaction fees earned on processing and converting card transactions from one currency into another currency. Foreign currency transaction fees earned under agreements with multi-currency processing services customers have traditionally been based on a fixed percentage applied to the net foreign currency margin earned, after deducting any merchant revenue and other contractual costs. Planet’s average gross markup has been ~3.8%, of which Planet keeps 30-35% on average, leaving the remainder to be split between the acquiring bank and merchant.

The primary drivers of revenue are the number of active merchant locations, the opt-in rate at the consumer level (for Pay in Your Currency), and the average net transaction mark-up.

Payment Processing Services:

Planet’s processing solution is delivered as a complete outsourced processing solution, providing all that is needed to support the processing of card transactions, including the following:

• Patented, real-time per-transaction exchange rate calculations that allow merchants to set rates on a per-transaction basis, based upon a number of business rules (U.S Patent No. 7,660,768)

• Communication of exchange rate information to a merchant’s point-of-sale to facilitate selection of currency

• Authorization and clearing of payment to the particular credit card association involved in the transaction

• Reporting and reconciliation of transactions to acquiring banks and merchants

• Multiple language support for acquirers and merchants

Planet’s Integration in the Processing Chain:

As part of its processing services, Planet also offers acquiring bank and processor customers consolidated reporting and data analytics. It provides value as an information and content manager for businesses, which have traditionally been subject to complications in their information streams caused by expansion into foreign markets and the introduction of different reporting systems and languages. Its centralized reporting platform can provide transactional data in a uniform, consolidated online format across a merchant’s international operations with the ability to focus on selected data according to a merchant’s particular requirements, including the ability to segregate reporting by region, market and currency.

Revenue for processing services is derived either as a fixed fee per transaction or a percentage of transaction value.

iPay Gateway & Facebook Integration

In addition to enabling acquiring banks and processors to offer merchants multi-currency solutions under their own brands, Planet also generates revenue from its direct merchant solutions including the iPay Gateway, its online payment gateway. This service allows for the processing of credit card, purchase card, debit, and electronic check payments through both business-to-business and business-to-consumer platforms, as well as multi-currency processing. Revenue is derived as a percentage of transaction value and/or as a per-transaction fee.

No-Brainer Value Proposition

Planet’s suite of multi-currency processing and data management tools are designed to facilitate commerce and improve customer profitability. The company’s multi-currency solutions drive incremental revenue for both acquiring banks (Planet’s primary customers) and their merchants, while providing end consumers with a superior service offering and payment certainty. At the highest level, Planet’s solutions shift the financial benefit and revenue earned on the processing of international transactions to the acquiring banks and merchants, from the historic beneficiaries, the card-issuing banks.

Acquiring banks – beneficiaries of Planet’s Solutions

Planet’s platform serves as an outsourced solution for acquiring banks that allows the provision of new, revenue-enhancing services without significant investment or modifications to existing systems.

Historically, acquiring banks have not shared in the revenue earned on the conversion of international credit card transactions; they would instead only collect fees on the general processing of merchant transactions in connection with the merchant’s agreement with the acquirer. Offering Planet’s multi-currency solutions provides acquiring banks a new revenue stream from collecting a share of the cross-currency margin earned on processing cross-border transactions. Accordingly, Planet’s solutions provide the acquirer substantial incremental revenue and increase the profitability of the acquirer’s general credit card processing operations. This incentivizes Planet’s acquirer clients to sell their merchant bases on the benefits of adopting Planet’s services, driving as rapid an uptake as possible and reducing the necessity for the company to build out a large sales force.

Further, Planet’s solutions provide the acquirer with an expanded product offering that acts as a powerful competitive differentiator and merchant retention tool.

Merchants – beneficiaries of Planet’s Solutions

The company’s services also provide merchants with an additional profit center, increase customer satisfaction, and drive an increase in sales through price localization.

According to The Green Sheet, “To be able to see the value of transactions in home currencies makes DCC an enticement for foreigners to shop in businesses that offer DCC.”

With PYC, the merchant also earns a share of the revenue from the cross-currency conversion.

Additionally, PYC eliminates the problem many customers experience due to currency fluctuations where the refund the cardholder receives is less than the original purchase price.

End Consumer – beneficiaries of Planet’s Solutions

Planet Payment’s DCC capability offers several benefits to cardholders. In addition to knowing that the amount they see on the payment page is the amount they will pay (i.e. no nasty surprises), the cardholders often receive a more competitive rate on foreign exchange than that provided by their credit card issuing bank. Generally, the cost attributable to DCC service is comparable to rates and fees that would have been paid had the card association and issuer performed the conversion. The consumer enjoys the convenience of paying for a purchase in his or her home currency at generally the same cost that would have been applied throughout the traditional process.

Also, since conversion is done at the point of purchase, cardholders are not subject to currency fluctuations which can occur over the period between the point of purchase and the conversion of the transaction by the cardholder’s issuing bank.

Issuing Banks – losers in the process

Issuing banks are being cut out in the process from participating in the fee stream from cross-currency conversion. Because transactions are processed and received in the billing currency, they do not earn the international transaction fee otherwise charged when a transaction is converted through the traditional process. The issuing bank does continue to earn the interchange fee (the percentage of each transaction that is collected by the card associations and paid to the issuer).

Credit Card Association – neutral

Planet Payment’s multi-currency processing solution is broadly revenue-neutral to the credit card associations (MasterCard, VISA, American Express, etc). They continue to earn cross border transaction fees charged to the issuers and acquirers on the processing of cross-border transactions.

As a matter of fact, the cross border transaction fees charged to acquirers, which are typically passed on to merchants, can provide a financial incentive for merchants to adopt Planet’s solutions, as the revenue derived from participation serve to offset these costs.

Market Traction

Planet typically partners with acquiring banks and processors, which seamlessly integrate the company’s solutions into their existing product offerings, which are in turn marketed to merchants under the brand of the bank or processor. Through this model, Planet is winning the business of leading international banks and processors, with >45 clients spanning more than 18 countries and territories.

Some of its leading customers amongst banks and processors across various markets include the following:

Planet also generates considerable revenue from its iPay payment gateway, which provides merchants with payment applications and sophisticated fraud and business management tools. It has attracted premier clients to adopting this service including the following:

• The Weather Channel

• Genzyme

• Nickelodeon Junior

• Stratfor

Benefitting from Strong Industry Tailwinds

Planet Payment is operating in the center of the largest growth areas in international payment processing – international eCommerce and multi-currency processing.

Continued Shift Toward Electronic Payment Transactions

The usage of electronic payments through credit and debit transactions has steadily taken market share from cash and checks in the past 20 years. According to The Nilson Report, a leading research provider for consumer payment information, it is estimated that credit and debit transactions may account for 75% of all transactions in the U.S. by 2015. From a global perspective, it’s estimated that total card spending will reach nearly $22 trillion by 2015, with nearly 60% of the transactions occurring outside of the U.S. and Europe

Many Large Markets are Still Highly Underpenetrated and Growing

Not surprisingly, the largest growth opportunities for Planet Payment continue to lie in the emerging markets. According to The Nilson Report, in 2010 there were ~1.9 billion payment cards in circulation in the US, Canada and Europe; those regions had a total population of ~671 million, representing ~2.86 cards per person. In the Asia Pacific region, Latin America, the Middle East and Africa, there was an average of only 0.81 cards per person.

Another way of looking at the size of the opportunity for increasing card payments is to analyze the card purchase volume as a percentage of GDP. For example, Brazil’s card purchase volume as a percent of GDP is only 8%, whereas more developed economies are above 20%.

Planet Payment launched multicurrency processing services in Singapore, Sri Lanka, the Maldives, Brunei, the Philippines, the United Arab Emirates and South Africa in 2010, with the results yielding strong results in 2011. Approximately 26% of the multicurrency settled dollar volume processed in December 2011 was attributed to new merchants activated in 2011.

In March 2012, the company announced it had entered into a contract to provide processing support across its platform for China UnionPay credit and debit cards. China UnionPay is one of the world’s largest card brands, with 2.8 billion cards issued worldwide. Chinese consumers were estimated to spend $55 billion overseas in 2011 and China UnionPay is one of the preferred payment options for Chinese travelers. It is expected this capability will be added to Planet’s platform in the second quarter of 2012.

In October 2011, Planet announced an expansion into Latin America, the hiring of a regional Vice President /Managing Director, and the establishment of a subsidiary and headquarters in Mexico City. Planet Payment currently has no revenues in Latin America, the fastest growing emerging market in terms of card payments. The company has indicated that they are in discussions with a number of prospective customers in the region, and anticipate announcing a contractual agreement in the near future.

The opportunity ahead in Latin America is further illustrated below by the success of MercadoLibre’s online payment service called MercadoPago, which is designed to facilitate transactions both on and off the MercadoLibre Marketplace by providing a mechanism that allows users to securely, easily and promptly send, receive and finance payments online.

Increased International Commerce

Visa reported that, for the 12 months ended March 31, 2012, cross-border payments and cash volume grew 15% year-over-year on a constant U.S. Dollar basis. MasterCard reported that for the 3 months ended March 31, 2012, cross-border volume grew 18% period-over-period on a local currency basis.

Increased eCommerce on a Global Scale

With the rapid increase in the number of Internet buyers worldwide, competition among eCommerce merchants is growing and becoming more global, and merchants must focus their resources on attracting consumers to their websites and making the buying decision as convenient and easy as possible. Growth in Internet usage, and eCommerce in particular, has a direct link to increasing electronic payments.

The data compiled by the U.S. Census Bureau indicates a steady growth profile in eCommerce retail sales over the past decade, and now exceeds $50 billion per quarter. However, this still only represents a little more than 5% of all retail sales in the U.S. On a global basis, Euromonitor International estimates a 90% increase in eCommerce sales by 2014. Internet penetration in emerging economies is still remarkably low at under 40% of the total population for countries such as India, China and Brazil, but is growing at a rapid rate of 30% per annum.

Management Incentives Tied to Shareholder Value Creation

For example, on July 26, 2011, the Company made a restricted stock grant of 915,000 shares of the Company’s common stock to the Chief Executive Officer, pursuant to its 2006 Long-Term Equity Incentive Plan. The 915,000 shares vest in four separate tranches, each with a different long-term performance goal. The agreement provides that (1) upon a corporate transaction, certain unvested shares accelerate and become vested, and (2) upon Mr. Beck’s involuntary termination, certain unvested shares shall remain outstanding and become vested only at such time as the performance goals applicable to such unvested shares are satisfied. The performance goals for each tranche are outlined below, and give an indication of where the company believes the valuation and share price potential is headed over the next 5 years. As part of the NASDAQ IPO the company has adopted a new 2012 Equity Incentive Plan and has reserved an additional 5.0 million shares.

Numerous Investment Highlights for Planet Payment

Planet Payment has a high-margin, recurring revenue model. Customers sign contracts typically for 3 – 5 years and the company earns a fee every time a purchase is made across its network. Once Planet breaks into a new geographic market, its acquiring bank customers take charge in selling its platform to merchants. In effect, once the company gets traction, it is order-taking rather than selling. Because of this, we believe Selling, General & Administrative expense will grow at 33-50% of the company’s revenue growth rate, resulting in a growing percentage of revenue falling to the bottom line.

Due to the scalability of the company’s technology platform, little is needed in incremental capital expenditure to support the company’s growth. We believe the company can support its growth at over the foreseeable future with ~$2.5 million in annual capital expenditure, $1.5 million of which is dedicated toward new development and $1 million of which is maintenance spend.

Significant Network Effects to Drive Sustainable Top-Line Growth

Once Planet gets traction in a given geographic market, acquirers not offering their merchant bases its services begin losing market share and increasingly seek to establish partnerships with the company to provide its services. As Planet signs up new merchants and market penetration deepens, the company is able to demonstrate the benefits of its services to other merchants who may also want to implement its services.

Planet’s business model benefits from powerful ‘network effects’: As the company acquires more active merchants and users, the value of its platform becomes more useful and valuable to all participants and prospects. These network effects appear to be at an early stage of development and are likely to be a material growth driver in the future.

Barriers to Entry and Scale

Creating a global payment platform requires significant domain knowledge and local expertise in each and every country and market. Planet Payment has invested heavily in the past 13 years to build a secure, robust, and scalable platform. The company has cemented strong relationships with the multiple parties required to successfully execute this business including acquiring banks, processors, and merchants. (See Appendix 4 for a more detailed list of partners.)

Differentiated Technology Advantage

Planet Payment has a differentiated technology platform. The company’s advanced payment processing services provide an end-to-end solution for its customers. When a merchant wishes to accept a payment using a payment card, the company receives an authorization request from a merchant’s point of sale. In real time, they submit that transaction to the card associations for authorization by the card issuer. Upon receipt of an authorization (or decline) they return the message to the merchant, which then completes the transaction with the cardholder. Currency transactions happen instantaneously under the company’s patented rate mark-up technology. Other competitors do not have this capability, and rely on the treasury method, which pools transactions and settles them on a delayed basis and makes it more difficult to scale.

Significant Cross-Selling Opportunities

Planet Payment has untapped opportunities to cross-sell its innovative services to acquiring banks, processors, and merchants. Its range of services and solutions enable cross-selling opportunities that are intended to increase revenue from existing customers by helping them broaden their product sets with additional value-add services. Customers have the ability to leverage the company’s unified global platform and enhanced services to improve operational efficiency. For example, an existing customer for Pay In Your Currency at the point of sale recently agreed to expand its use of the company’s services to include Pay In Your Currency at ATMs, which is expected to launch in the second quarter of 2012. Cross-selling opportunities are still at a very early stage of penetration and represent a significant incremental margin opportunity because there are lower customer acquisition and integration expenses.

SWOT Analysis Summary

Below we provide a traditional “SWOT” analysis to outline the major strengths, weaknesses, opportunities, and threats facing Planet Payment. On balance, we believe the company’s strengths and opportunities outweigh its threats and weaknesses.

Attractive Capital Structure and Institutional Support

Planet Payment has an attractive capital structure with only 69 million fully diluted shares and no financial debt.

Acquisition Candidate in a Rapidly Consolidating Industry

Planet Payment is a leading independent payment processor with a fast-growing, high margin, difficult to replicate multi-currency business as the key growth driver. This gives it some scarcity value in an industry characterized by accelerating M&A activity.

Strategic acquirors have shown the willingness to pay high multiples relative to revenue, EBITDA, and earnings for companies that have built their own processing platforms, possess unique technologies and have acquired attractive customer bases. This is because a differentiated payment processing platform is highly leverageable. We believe acquirors are not just paying for a stream of profits, but also a scalable technology platform to leverage larger transaction volumes and generate significantly more profits.

The table below lists transactions that have taken place in the industry over the past several years. We believe it is most instructive to focus our analysis on less mature, high margin targets that developed their own processing platforms and had unique, hard-to-replicate technologies (and to exclude from our analysis mature targets and those acting simply as merchant acquiring ISOs).

• In February 2008, Intuit bought Electronic Clearing House for $131 million, or ~25x LTM EBITDA of $5.3 million. ECHO owned its underlying processing technology. This wasn’t the first time an eCommerce company linked up with a payment processor in hopes of growth; eBay purchased Paypal in 2002 (for 60x LTM EBITDA) and saw its profits rise by creating an end-to-end payment service for its customers. Intuit similarly expected to boost its revenue by collecting transaction fees every time someone makes a payment through its core software offering. Intuit announced that the deal provides Intuit with access to a valuable list of new customers, including large retail and hotel chains.

• In April 2010, Visa acquired Cybersource for $2 billion, or 31.5x LTM EBITDA of $63.5 million. Cybersource is a payment gateway for online merchants. The company owned a valuable processing platform with a deep list of big online merchants, including Home Depot and Google.

According to Visa, “With CyberSource, we are adding a new suite of leading eCommerce capabilities and experience in addressing eCommerce merchant needs… Online commerce continues to grow rapidly, and this acquisition will enable Visa to offer new and enhanced services that will better meet the growing demand among merchants globally… The acquisition of CyberSource aligns with Visa’s long-term strategic plan to identify and invest in opportunities today that will drive future growth…”

• In August 2010, Mastercard acquired DataCash for $520 million, or 19.5x LTM EBITDA of $26 million. Datacash is an international provider of credit and debit card transaction processing and secure internet payments. Mastercard justified its purchase as follows: “eCommerce represents an important part of MasterCard’s growth strategy, and this acquisition will allow us to provide new services to our acquiring customers, as well as drive increased eCommerce penetration in both existing and new markets. The acquisition of DataCash will expand our already significant eCommerce merchant gateway presence in Asia and Australia to European countries and other high-growth, emerging markets worldwide.”

Strategic acquirors pay top dollar for payment processors whose unique technologies they can leverage and use to grow their revenue streams. They also place a high value on deep and extensive customer relationships through which they can cross-sell services.

Planet’s solutions are creating change in its industry, shifting the balance of power from issuing banks to acquiring banks and processors and offering those institutions access to a piece of a very large potential profit stream.

We believe the company is positioning itself to be a part of a larger organization and that it will be an attractive acquisition candidate for many financial industry players in the next few years. A strategic acquiror would be buying a highly flexible multi-currency payment processing platform and an attractive customer roster of large eCommerce merchants and leading international banks and processors (and through them, large, international retail and hotel chains). As history would suggest, we believe this justifies valuation multiples at the upper end of the range for precedent transactions (>18x EV/EBITDA, 3x – 4x EV/Sales, and 25x – 35x Price/EPS).

Valuation and Price Target

We believe with a reasonable certainty that in light of the company’s dominant competitive position and its growing market opportunity, that Planet can continue growing its top line at 30-40% per year for the next 3-5 years, and at a much higher rate in the upside scenario should the company land very large international acquirer accounts or successfully leverage its platform to expand into other areas of processing. If this takes place, we expect a return of 3-5x from current trading levels, and we believe the risks to our estimates are skewed toward the upside.

Based on various valuation methodologies, we believe Planet today has a fair value of $8 per share. Our valuation is based on earnings projections spanning the next 5 years. The company’s stock price appears to undervalue the company’s prospects and its impending IPO on the NASDAQ may serve as a catalyst to unlock value from the current stock price.

Comparable Companies Analysis

Given Planet’s rapidly accelerating profitability, it is difficult to justify the use of mature sector peers as a relative valuation tool. However, below we have included for reference an analysis of publicly traded companies in the financial transactions and processing sectors. Valuations range from 16x -20x forward P/E, 9x – 12x EV/EBITDA, and 12x -20x EV/Cash from operations. Planet appears rich based on these metrics.

But the company’s unique position as a multi-currency processor with related data analytics and gateway operations makes a direct comparison with sector peers inadequate.

The following charts illustrate why investors appear to be placing a premium valuation on near term earnings. The company’s revenue and growth rates are the highest in the industry, and it has an unlevered balance sheet and a return on invested capital comparable with its peers but set to surpass the average over the near term.

Discounted Cash Flow Analysis (DCF)

Using a traditional DCF analysis, we arrive at our share price target of $8.00 by projecting unlevered free cash flows, and applying an 11x – 13x terminal multiple to 2016 EBITDA based on the comparable companies and precedent transaction analyses. Our base case weighted average cost of capital (WACC) assumption is 9.5%. Given Planet Payment’s current share price of $4.30, we believe the stock is undervalued today and has significant room to appreciate as the company grows in the coming years.

Near-Term IPO a Potential Catalyst for Stock Price

In May 2012, the company filed an amended S-1 offering document to register shares for a listing on the NASDAQ. At the current time, it appears the offering will be $75 million in size, but it is still unclear what percentage of the offering will be newly issued shares vs. shares being sold from existing investors.

JP Morgan, William Blair & Company, and Jefferies are listed as the leads of an 8-bank underwriting syndicate for the offering. Several banks of this group are likely to follow the offering with research coverage of the company. The NASDAQ listing will provide greater liquidity for shareholders vs. the existing OTCQX listing, and help to raise the visibility and profile of the company to new investors, potentially serving as a powerful catalyst to unlock value from current trading levels.

Conclusion

Planet Payment has built a defensible business that is at the forefront of a nascent, rapidly growing segment of the payment processing industry. It has developed a unique processing technology platform that allows its customers to add a profit stream to their existing operations and as a result, is deepening relationships with its client base of leading international banks and processors and rapidly attracting new, sticky business. These qualities make Planet an attractive acquisition target in a rapidly consolidating industry.

We believe the company has a clear runway to continue growing revenue at 30-40% per annum over the next 5 years and that operating leverage will allow it to grow free cash flow at a much higher rate. Based on our analysis, the equity has a fair value of $8 per share, representing little risk of permanent capital impairment over a multi-year horizon from current trading levels. Its near-term IPO and resultant exposure is likely to serve as a catalyst to drive the equity toward our fair value estimate.

Legal Disclaimer

As of the publication date of this report (the “Report”), Prescience Investment Group, LLC, its affiliates, and others that contributed research to the Report (collectively, the “Authors”) have long positions in the stock of Planet Payment, Inc. (the “Company”) and stand to realize gains in the event that the price of the Company’s stock rises. For this reason, the opinions expressed in this Report should not be considered to be independent. Following the publication of this Report, the Authors expect to transact in the Company’s securities covered in the Report and may increase or decrease their investment in such securities. The Authors have obtained all information herein from sources they believe to be accurate and reliable. However, such information is presented “as is”, without warranty of any kind, whether express or implied. The Authors make no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. All expressions of opinion are subject to change without notice, and the Authors will not undertake to update this Report or any information contained herein. Please read our full legal disclaimer at the end of our full report here.

Our customer interviews feature recorded conversations with ABAT customers. After visiting one of ABAT’s plants, one customer called the facility “absolutely the biggest joke I’d ever seen”. In another conversation, a customer said the CEO admitted to hiring an accounting firm “to cook his stock price up”.

Some of our arguments have been discussed in prior Seeking Alpha articles by other authors, including here, here, here, and here. For instance, in our report, we discuss how ABAT’s SAIC filings show that the company’s actual revenue and profit are a fraction of what is reported in SEC filings. We also show that ABAT’s $20 million acquisition of a Shenzhen battery company appears to be a sham, and that ABAT paid $20 million in 2010 for an entity that they had previously bought in 2008 for $1 million, but had not disclosed to public investors.

In this article, we’re going to highlight new information that ABAT is falsifying its financial statements, including:

A comparison of the profit margins of ABAT to 106 global battery makers as provided by Bloomberg and a list Chinese battery makers as provided by Research and Markets in its “Global and China Rechargeable Lithium Battery Industry Report: 2009-2010” industry report. ABAT shows the highest profit margins out of any global and Chinese battery maker, despite having no technological advantage, limited operating experience, an unrecognized brand name, and production facilities too small to claim economies of scale.

Site visits show underutilized facilities lacking in quality control. We hired investigators to visit both the Harbin and Wuxi facilities, and provide photos as well as commentary from our investigators in our report. Our investigators concluded that both facilities produce commodity, low-margin products that are highly unlikely to be generating industry-leading margins or return on capital.

Extensive discussions with customers and partners that confirm our beliefs that ABAT is fabricating its financial statements

Impossible Economics

Selling a commodity product into a competitive market with no technological advantage is difficult. It’s especially difficult for a small business without economies of scale, limited customer relationships, and no distinguished brand name. But ABAT purports to be not just surviving, but thriving with industry-leading margins and an ROIC that warrants explanation.

A company with an EBITDA margin of 45% in 2010 must have some uniquely special competitive advantage. Yet ABAT itself recognizes that it has no special technology for its main products. The following is taken from its annual report:

The technology utilized in producing polymer lithium-ion batteries is widely available throughout the world, and is utilized by many competitors, both great and small. ZQ Power-Tech’s patents give it some competitive advantage with respect to certain products. However, the key to competitive success will be ZQ Power Tech’s ability to deliver high quality products in a cost-efficient manner. This, in turn, will depend on the quality and efficiency of the assembly lines that we have been developing at our plant in Harbin.

In choosing a set of comparable companies for ABAT, we’ll use companies listed by Bloomberg in its “Batteries/Battery Systems” industry classification.

The results are startling. In terms of EBIT margin, ABAT ranked #1 out of 106 global companies, with an EBIT margin of 39%, compared to 23% for the next closest competitor Exide Industries Ltd of India, a $40 billion revenue business.

Out of the 106 companies provided by Bloomberg in the “Batteries/Battery Systems” classification, Bloomberg records the EBIT margins for 79 of them (the remaining companies’ margins are shown as “N.A.”). ABAT reports a 39% EBIT margin. Only three other companies report EBIT margins above 20%, one of which is NEWN, another suspect Chinese reverse merger company. Only 10 companies report EBIT margins above 15%. ABAT, a company with less than $100m of sales and a relatively tiny player in a commodity industry, is an extreme outlier in our analysis. ABAT also comes up top in other profit margin metrics, with the #1 ranking in EBITDA margin and #2 ranking in net income margin.

Is it possible that a company with only about 5 years of operating experience is generating higher margins than a company such as Energizer with its 15% EBIT margins, based on the “quality and efficiency of the assembly lines”?

Perhaps it’s ABAT’s position in China and access to cheap labor that gives it such an amazing edge in the global arena. We can test this hypothesis by comparing ABAT to a handful of other Chinese battery manufacturers. The independent third party research organization Research in China publishes an annual report titled “Global and China Rechargeable Lithium Battery Industry Report”. In the 184 pages of the 2009-2010 edition, no mention is made of ABAT or its subsidiaries. The report does, however, make mention of China BAK Battery Inc. (BAK), BYD Company (BYD), SCUD Group Ltd, and Tianjin Lishen, which generate respective revenue of $222m, $5,805m, $185m, and $295m.

Other Chinese battery manufacturers which are not active in the lithium polymer market can also be compared to ABAT. Examples include the Coslight Technology International Group Limited and Tianneng Power International Limited, with $352m and $330m of revenue respectively in 2009. Gross margins and operating profit margins for all six of these companies, as well as ABAT, have been summarized in the table below for the most recent available fiscal year:

Company

Gross Margins

Operating Profit Margins

China BAK Battery, Inc.

10.6%

-9.7%

BYD Company

17.7%

7.3%

SCUD Group Ltd

18.1%

5.8%

Tianjin Lishen*

5.4%

Coslight Technology

26.6%

9.1%

Tianneng Power

28.5%

14.3%

ABAT

47.3%

39.0%

*This is a subsidiary of CNOOC and financial statements were not readily ascertainable, although it is evident that the Research In China report is using numbers specific to Tianjin Lishen.

ABAT’s operating margin is nearly triple that of its closest competitor and six times that of the median operating margin of our Chinese battery makers.

Obviously, strong operating performance alone would not normally be cause for concern. But when a company is doing as well as ABAT, investors need to understand why or how. ABAT clearly states in its annual report that it has limited (if any) technological advantage, and is competing in what is predominantly a commodity market. We have spoken to a customer who has visited ABAT’s Harbin battery manufacturing plant, and he has stated that there was nothing uniquely special about the Harbin facility. We also hired investigators to visit the Harbin facility and their findings are discussed later in this article.

The founder of ABAT, Zhiguo Fu, established it in 2001 without any prior knowledge, experience, or expertise relating to batteries or manufacturing. Fu’s background is in real estate. Furthermore, this company didn’t begin manufacturing until 2006. ABAT has limited operating experience, an unrecognized brand name, and production facilities too small to claim economies of scale. Yet it seems like no matter how we compare ABAT to its competitors, ABAT’s financial figures come out ahead despite the numerous causes for concern discussed elsewhere in our report.

Wuxi ZQ and Heilongjiang ZQPT Site Visit

As part of our investment research process, we sent an experienced factory inspector to both the Wuxi electric vehicle facility and the Harbin battery facility. What we found was not encouraging.

Summary points from the Wuxi visit included:

Out of four assembly lines, only three were operational.

Staff included 200+ workers, but only 20 are office workers, indicating likely weaknesses in R&D, engineering, QC, and sales.

Factory management indicated 20,000 unit sales for 2010, with prices ranging from $450-$920 USD. This compares to 90,000 units reported to us by ABAT VP of Finance Dan Cheng on a conference call, a number which can also be backed into using data provided in ABAT’s 10-k.

The facility does not have a motorcycle manufacturer’s permit issued by the Chinese government.

Management claims to use the VIN of a partner, which is illegal.

Our investigators’ greatest concern was the lack of quality control (QC).

No line inspector or inspection of finished products.

No inspection list attached to each bike.

No testing center inside the factory.

The facility lacked basic equipment to test different parts for new product development.

Motor speed and efficiency testing machines were present, but no noise, temperature, or salt-fog testing machines.

As lacking as the facilities were in the Wuxi facility, the Harbin site visit was even more disturbing in light of the world-class margins and the Company’s reliance on this facility to support the bottom line.

Our investigators concluded the following:

It appears that the Harbin plant is in operation, does produce cells, and has sales. The semi-automated processes… are more advanced than some of the battery companies of China, and far less advanced than battery companies of international standing such as ATL, Lishen, Samsung, LG Chem. It appears that they do some things well, and have some potential great strength, but appear to have limited ability and concepts in the marketing and sales of their product. Selling cells to packagers is a common business model for Asian battery factories, but not one that realizes as much profit. And I note that the CTO acknowledged that the packagers and trading companies were making the entire margin and he was not. Again, normal for Asian cell makers – but not a way to gain success.

A proprietary BMS (Battery Management System) is essential for a successful battery company in the Light Electric Vehicle space. And the lack of such is a major handicap for Harbin. It appears to me that this company has a tiny business selling Li Ma or LFP (Lithium Iron Phosphate) cells to packagers for use in low priced battery packages sold to the domestic China market. This is the least profitable business they could have. The LI-Polymer cells are apparently not really in production (the normal issue with Li poly) due to high cost of materials and resulting high cost of the cells making them uninteresting to most applications. The LFP cells cannot be exported due to patent issues… So the only apparent product for any significant sales would be Lithium Manganese cells, and for that to make money for Harbin they would, probably, need to develop their own BMS, become their own packager, and compete with Phylion, Zhenlong, AEE, MGL, LG Chem, Lishen, HYB, and others.

Conversations with ABAT Customers

Since Advanced Battery’s inception, management has made numerous claims regarding relationships with suppliers, distributors, research partners, and other related parties. As part of our due diligence process, we attempted to contact most of the relevant parties that ABAT has mentioned having a relationship with. In many cases, the parties we have contacted have been nonexistent, non-locatable, unwilling to speak, or had something strongly negative to say about ABAT.

In multiple cases, we found customers who either came away from their visits to the Company’s factories unimpressed or confident that the Company was inflating its financial figures. In this section, we provide a recording with one such customer, but have concealed and modified his voice.

This customer had signed a contract to receive scooters from ABAT’s Wuxi facility in 2009. After receiving defective product, the customer demanded to visit the Wuxi facility that had supposedly been manufacturing the scooters. During our conversation, the customer indicated that he had visited numerous other Chinese manufacturing facilities to which Wuxi could be compared, and he described the Wuxi facility as a “joke” multiple times. The facility was described as “four empty walls”, the inadequacy of which made him suspect Wuxi was some sort of distributor operation rather than a manufacturing facility. Furthermore, the customer stated that he thought about contacting the SEC to report ABAT for fraudulent claims made in press releases. He said that “none of the stuff they put out was accurate”.

Other customers we’ve been in touch with have voiced similar opinions of ABAT. For example, in 2010 ABAT touted an agreement to re-enter the US market, expecting to deliver 200,000 electric scooter units to All-Power America for $1.1 million. Only half the delivery was taken before serious issues surfaced regarding quality control and licensing. The following comprises one excerpt from the long conversation we had regarding these issues and more with an All-Power executive:

All-Power:

Every step of the way we had some serious QC issues… The licensing is the official word that we gave out to everybody because that was a very tangible problem that the retailer used to return the products. But licensing was a major part of it, they should have checked for licensing compliance before they sent it.

Prescience:

So Wuxi, which is the company that you got the cycles from, they sent you shitty product, am I reading you right? I’m not sure if I follow you?

All-Power:

Yeah, and that caused a major loss of confidence with our customer. Plus we missed a lot of deadlines, and the customer said “you missed a lot of deadlines plus you have licensing issues, we’re going to send you all of them back”. So they put them on trucks and sent them back. Now we’re stuck with the inventory that I don’t know how the hell to move.

Wuxi ZQ mentions additional customers in its February 3, 2010 press release and its 2010 10K. We review our diligence with many of these customers in our report.

Conversations with ABAT Partners

Alongside numerous ruined or strained customer relationships, we have also uncovered a number of failed partner relationships. In our report, we discuss our conversations with ZAP and Altair Nanotechnologies, as well as our attempts to contact numerous other ABAT partners. Our conversations, as well as our inability to locate many of ABAT’s obscure or hard-to-locate partners, reinforced our belief that ABAT’s business is much smaller than its SEC financial statements indicate.

Conclusion

Our longer report elaborates on the evidence discussed in this article. Our evidence that ABAT is falsifying its financial statements includes:

SAIC filings show that ABAT is reporting significantly lower revenue and operating losses to the authorities in China. For 2009, SAIC filings showed less than $2 million of revenue, compared to $64 million in SEC filings.

ABAT has unreasonably high margins in an established industry with strong competitors. The Company’s SEC-reported margins and return on capital are virtually impossible. Out of 106 global battery manufacturers as classified by Bloomberg, ABAT has the highest operating profit margin by a wide margin. When compared to six leading Chinese battery makers, ABAT’s operating margin is triple that of its closest competitor and six times that of the median operating margin of the comparable companies.

Site visits show underutilized facilities lacking in quality control. We hired investigators to visit both the Harbin and Wuxi facilities, and provide photos as well as commentary from our investigators. Our investigators concluded that both facilities produce commodity, low-margin products that are highly unlikely to be generating industry-leading margins or return on capital.

In December 2010, ABAT announced that it was acquiring a Shenzhen battery maker for $20 million. We believe this acquisition is a sham, and that ABAT paid $20 million in 2010 for an entity that they had previously bought in 2008 for $1 million, but had not disclosed to public investors.

Confirmation from former customers and partners that the Company is likely a fraud. After visiting one of ABAT’s plants, one customer called the facility “absolutely the biggest joke I’d ever seen”. A recording of the conversation is available here. In another conversation available here and here, a customer said the CEO admitted to hiring an accounting firm “to cook his stock price up”.

Low quality auditors and high turnover. The company has had 4 auditors in the past 7 years, with no auditor being ranked in the top global 100 auditors at the time of hire.

Unqualified CFOs and high turnover. A CFO or auditor has resigned at least once a year. The Company’s past three CFOs have included: (i) a company insider who has been general manager of the Company’s main operating subsidiary since 2004, and is therefore not remotely independent, (ii) a 29-year-old who was formerly VP Finance at China Natural Gas, another fraud, and (iii) a candidate whose primary experience comprised of being a financial adviser at Smith Barney.

Continuous share dilution through secondary offerings, despite having more than adequate cash reserves. Through repeated share issuances, the Company has grown its outstanding shares from 10.0 million following the 2004 reverse merger to 76.4 million today.

Disclosure: As of the publication date of this report, the Prescience Investment Group has a short position in and owns options on the stock of the company covered herein (Advanced Battery Technologies, Inc.).

Disclaimer: Following publication of the report, the authors may transact in the securities of the company covered herein. The authors of this report have obtained all information herein from sources they believe to be accurate and reliable. However, such information is presented “as is”, without warranty of any kind – whether express or implied. The authors of this report make no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. All expressions of opinion are subject to change without notice, and the authors do not undertake to update this report or any information contained herein. Please read the full legal disclaimer at the end of the written report for which a link is provided in this post.

]]>http://presciencefunds.com/abat-report-sec-filings/feed/0Active Power (ACPW): Likely to be Multiples of the Current Price Over a Multi-Year Horizonhttp://presciencefunds.com/active-power-acpw/
http://presciencefunds.com/active-power-acpw/#commentsFri, 12 Mar 2010 06:43:45 +0000http://presciencefunds.com/wordpress/?p=86Active Power is a defensible business that’s likely to trade at a multiple of the current price over the next several years. It’ll pay to get to know what it’s all about and to understand the changes it’s driving in the space for energy storage.

Description of business and company background

The continual, exponential expansion in the volume of data (e.g. think of the number of email accounts being created, credit card transactions being processed, YouTube videos being uploaded, etc) is driving a secular expansion in the build-out of datacenter facilities, which house and store data. With new datacenter facility build-outs as its #1 end market, not only is Austin-based Active Power well-positioned to capitalize on this trend, it’s also revolutionized how consultant engineers think about continuous power

Datacenter facilities have a zero tolerance for energy blackouts, which can lead to revenue losses, customer defections, etc. Uninterruptable Power Systems (UPS’s), which protect these facilities against voltage fluctuations and provide ride-through power to bridge the 8-15 second gap between power outage and diesel generator start-up, are necessities in the build out of datacenters: They are essentially insurance on continuous power. Active Power is a leading manufacturer of flywheel-based Uninterruptable Power Systems (UPS’s) – insurance.

Unlike most of its competitors which utilize lead-acid battery based technology in their UPS’s, ACPW’s products utilize a patented flywheel-based UPS system which stores kinetic energy by spinning a compact steel wheel (“flywheel”) at several thousand RPM while the utility power is running normally. Then, if the utility power fluctuates or is interrupted, the flywheel’s inertia causes it to continue spinning. The resulting kinetic energy of the spinning flywheel generates “bridging power”.

We have developed a high degree of comfort from numerous conversations with customers, industry experts and competitors that ACPW’s flywheel products provide many competitive advantages over conventional battery-based UPS systems, including a lower total cost of ownership, substantial space savings, higher power densities, “green” energy storage, and higher power efficiencies (and hence, lower total cost of ownership).

This product’s been around for a long time – about a decade – and it takes these engineer-types a really long time to put their necks out in terms of trying something new. And this is the story here. There is enough data at this point to have proven the flywheel’s benefits over conventional energy storage, and the company has taken enough market share at this point that we believe market adoption to have hit an inflection point and to be on a steep rise.

We have prospected the company’s manufacturing facility in Austin and have been engaged in a frequent and ongoing dialogue with the CEO and CFO since the beginning of 2009. Jim Clishem was named CEO in 2006 and John Penver CFO in 2005. Since they took the helm, the company’s made substantial strides in creating a viable business and is currently on the path of growth through the disintermediation of market alternatives… yeah, it’s expanded its sales footprint into new global markets; expanded its direct sales distribution channel (previously distribution was primarily driven by OEM Caterpillar); increased focus on generating recurring, high-margin service revenues; and has facilitated the improved market acceptance of flywheel technology. To sum this up, we like management.

Market Opportunity

Active Power has traditionally sold into a UPS target market that measures $2.1 billion and that through 2008 was expanding at an annual growth rate of 12-14%. Over the period 2006-2008, ACPW grew its sales at a compound annual growth rate of 34%, indicative of expansion of share.

The credit crisis and resultant economic uncertainty led many companies to delay their build-outs of new datacenters. We believe the market was at the time already nearing capacity and that as of 2010 it entered a state of under-capacity in the US, with demand continuing to build. As such ACPW’s full year 2009 sales came in flat relative to 2008’s at ~$42MM. This said, 2010 has been a banner year for the company and recent action in the stock price tells the story: Revenues will exceed $60MM this year and we are expecting significant top-line growth over the years to come. I view 2009 as the recoiling of a spring, as happened with Intel way back in the day. (Don’t ask me about Intel’s story because I’ve forgotten the year I’m referring to and am not about to waste time researching for it.)

ACPW recently introduced a containerized, all-in-one continuous power solution product (“Powerhouse”) that is being sold alongside Sun Microsystems’ and HP’s modular datacenter solutions. By integrating ancillary products alongside its UPS’s, this product has expanded ACPW’s addressable market potential by about 4x, to ~$6 billion.

ACPW competes primarily with conventional battery-based UPS manufacturers (i.e. Emerson/Liebert, Eaton/Powerware and APC/MGE) – this is the competitive inferior – and KE-based rotary systems producers (i.e. Pillar, Eurodiesel, and Hitec). The rotary systems producers command almost half of ACPW’s UPS market segment. Their product is similar to a flywheel type of system, but with key differences in how the wheel is linked to the backup generator. ACPW competes with these companies based on the decoupling of power storage and backup, as well as modularity. Rotary companies compete on their strong brands, service and better distribution.

Based on the sum of our due diligence, when it comes to UPS, KE storage technology is indeed superior to that of batteries and we anticipate seeing continued market share gains from lead-acid counterparts. This will be the ‘low hanging fruit’ going forward – continued growth in market acceptance and market entrenchment of battery alternatives. And, it’s plausible that the well-capitalized battery suppliers eventually make acquisitions to deal with the continual decline in their piece of the pie. Liebert, Eaton, APC – they will all need to remain competitive in the +100kW energy storage space. As the rotary providers continue to grow, the flywheel manufacturers are well-positioned as targets — eh emm. By that I mean that ACPW might be well-basted turkey on Thanksgiving. Happy Holidays.

Economics

ACPW is a relatively early-stage story on the verge of breaking a profit this year. Most companies don’t appear on many investors’ radars until reaching profitability; we have found that identifying those approaching that inflection point particularly rewarding in the past.

Its break-even point depends on its sales mix. It has to sell the equivalent of 125 flywheels per quarter at an average unit price of $80k to break even. Alternatively it can hit break-even by selling 100 flywheels and 2 Powerhouse units. (As the Powerhouse business grows, revenue expands while gross margin per flywheel declines, partly offset by an associated rise in high margin consulting and maintenance services.)

Margin drivers:

The company IPO’d in August 2000 at $17/share, raising a net $126MM. Lead underwriter Goldman Sachs at the time prognosticated $120MM in revenue for the company by 2002; at the time ACPW’s revenues over the previous twelve months totaled $2MM. As it were, revenue peaked at $22MM in 2001 before falling to $8MM by 2003. By this time, the funds raised in the IPO had already been used to lease/equip a 127k sq ft manufacturing facility to support projected sales volumes. Simply put, there is a lot of unabsorbed overhead embedded in the company’s gross margins, currently on a run rate of 25-30%. As it expands, ACPW should benefit from a high degree of operating leverage and has the capacity to support revenues of $200MM with little incremental capital expenditure.

Management is increasingly focused on growing its direct sales channel. Historically, most of ACPW were made indirectly through OEM partner Caterpillar. Caterpillar is ACPW’s primary OEM customer and its largest single customer. CAT accounted for 35%, 31%, 40% of total revenue in ’06, ’07, and ’08, respectively. By selling away from CAT, directly into its end markets, ACPW is able to build a service book. The recurring, 50-60% contribution margin service business is the hidden gem here. Over the long term, management expects to be able to drive servicing fees to 20-25% of total revenue.

Ownership / Board

The period 2003-2006 was marked by headcount reductions and a management / board shakeup. Led by founder Joseph Pinkerton, previous management came into the company with tremendous intellectual property and a great patent portfolio but had failed to successfully commercialize product. With new leadership, ACPW would emerge with increased emphasis on sales and marketing on a worldwide basis.

On a fully diluted, combined basis, insiders own 8.5% of the company. Several directors as well as the CEO purchased material amounts of stock over the course of 2008 and 2009.

Current Valuation

We started looking at this company when it traded at $.30/share and acquired our position at prices between $.72 and $.80 per share. At this point the shares are a bit rich. The sell-side’s been upping their price targets and liquidity has flown into the company’s shares. I think the hot money’s got to come out and would suggest accumulating shares as the company cheapens, perhaps below 1.60/share should it again touch those levels. At the end of the day, this is a company to be owned for a long time. A long long time…

We believe the company can grow to exceed $150MM in revenue over three to five years (and if things go really right for it, revenues can go wayyyyy higher), over which time we expect the adjusted net income margin to increase to 11%. We also expect over this time the company will have accumulated cash of $25MM (including $17MM from the exercise of options). We attach a $25MM value to the company’s $180MM in net operating loss carryforwards and value the operating assets at 20x fully-taxed earnings, resulting in an EV of $330MM and market cap of $380MM, resulting in a per share price of ~$4.50… again over the next few years. A 20x multiple is warranted ACPW’s substantial competitive advantage, attractive growth prospects, clean balance sheet, and a business model with a significant chunk of recurring, high-margin revenues.

Key Risks

We believe the key risk to the company lies in an intensification of competitive pressures and therefore pressures on product pricing and margins. Should battery based technology become more competitive or should the rotary suppliers develop a technological edge versus flywheel mechanics, we would expect end market demand to respond accordingly. Additionally, given the early-stage nature of this company, results are likely to be volatile and clumpy. The company may in the future need to raise additional equity capital which could dilute the stakes of current shareholders, but I’m doubting it will have to to get to where I think it’s bound to go.

Disclosure: As of the publication date of this report, Prescience Investment Group holds an equity position in this company.

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